Tuesday, March 02, 2010

Latvia, Ukraine & Devaluation Issue Revisited

Contrary to what Krugman and Hugh seems to think, no one is denying that Latvia has suffered very badly during the latest slump, and from what I can tell that also includes the story in The Economist, as it frankly notes the big slump in GDP and the high unemployment rate.

The point of the story is simply to note that the people who argued that a Latvian devaluation was inevitable have been proven wrong. The Latvian government and most Latvians remains firmly committed to the peg to the euro and later adoption of the euro as currency. And with a large current account surplus, and with radical fiscal austerity measures combined with loans from the IMF, they won't be forced to do so against their will because of liquidity problems. Meaning that a devaluation at this point looks extremely unlikely, something which proves the people who thought that devaluation was inevitable wrong.

What Krugman and Hugh in their answers seem to do is try to shift the discussion from whether devaluation is inevitable (and whether it was ever reasonable to believe that) to whether it would have been or is desirable, an issue that wasn't at all discussed in the article they fume about.

It is of course true that just because something isn't inevitable doesn't mean that it's not desirable. There are lots of desirable things which unfortunately aren't inevitable or even likely. However, it is also the case that just because the Latvian economy is weak doesn't mean that devaluation would improve this situation.

If the alternative is worse, even bad things are preferable. The Czar of Russia and the Shah of Iran were arguably bad rulers, but what replaced them in 1917 and 1979 respectively were far worse.

Simply writing that Latvia's "internal devaluation" has been limited so far begs the question since it assumes that large (negative) real exchange rate movements are the key to prosperity-which is hardly self-evident.

I have dealt with the issue from a theoretical point of view here, where I concluded that devalution was in fact a worse option.

But that's "liquidationist" Austrian theory, some will think. "Look at how Latvia is suffering in the real world"! But again, the issue isn't whether Latvia is suffering or not (it clearly is), but whether or not they would suffer less with devaluation. And while everyone focuses on the suffering of Latvia, the equally large suffering of another country which used to be part of the Soviet Union, Ukraine, is conveniently forgotten. This is rather remarkable given the fact that Ukraine is in terms of population roughly 20 times bigger than Latvia (The Ukrainian capital of Kiev alone has more people than all of Latvia). If anyone of these two countries would be forgotten, you would have thought that it would be the far smaller Latvia rather than the far bigger Ukraine.

The fact that Ukraine has suffered badly of course doesn't prove that they would have suffered less without devaluation. This issue should be dealt with on a theoretical level, which again, I've already done. But the point is that Ukraine proves that countries can suffer dramatic drops in output even with devaluation, and that it is clearly wrong to assume that it can prevent such pain. And so, arguments againt my theoretical analysis should consist of theoretical counter-arguments.

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